SCHD Pays About 3%. This Covered Call ETF Pays 6% Without Eroding NAV

I’ve got nothing bad to say about the Schwab U.S. Dividend Equity ETF (SCHD). It charges just a 0.06% expense ratio and follows a solid methodology that screens dividend-paying stocks using measures including free cash flow relative to debt, return on equity, dividend yield, and five-year dividend growth. Right now, investors are getting a 3.15% 30-day SEC yield, and SCHD is also fairly tax efficient because its underlying index excludes real estate investment trusts (REITs).

If you want more income, though, there are plenty of ways to get it, particularly with covered calls. The problem I see with some of the double-digit-yielding ETFs is net asset value (NAV) erosion. The ETF keeps handing investors large distributions while the value of their shares gradually declines because the strategy isn’t generating enough economic return to sustainably support the payout.

Remember that yield isn’t free. On the ex-distribution date, an ETF’s NAV falls by the amount of its distribution, all else being equal. A 12% yield doesn’t do you much good if you’re collecting enormous distributions while your principal steadily disappears. That’s why I’d rather look for a more sustainable middle ground.

One candidate is the Amplify CWP International Enhanced Dividend Income ETF (IDVO). Its most recent monthly distribution works out to an annualized yield of roughly 6.1%, nearly twice SCHD’s current SEC yield, without requiring the fund to target the double-digit payouts where NAV erosion can become a bigger concern.

How IDVO Generates Its 6% Yield

IDVO is actively managed by Capital Wealth Planning and generally owns between 30 and 50 international stocks selected from the MSCI ACWI ex-U.S. Index. The managers look for companies they believe can increase their dividends, emphasizing characteristics including earnings growth, free cash flow, dividend growth, return on equity, market capitalization, and management quality.

International stocks already provide a decent starting point for income. IDVO estimates that approximately 3% to 4% of its return potential can come from dividends alone. It then attempts to enhance that income with another 2% to 4% from selling call options.

The implementation is important. IDVO doesn’t mechanically sell calls against an international index such as the MSCI EAFE every month. Instead, Capital Wealth Planning can write calls tactically against individual holdings in the portfolio.

That gives the managers considerably more flexibility over how much upside they’re willing to sell. They can vary strike prices, expiration dates, and overwrite ratios depending on their outlook for individual stocks and market conditions. The objective is to collect additional option premium without consistently sacrificing as much upside as a mechanical covered-call strategy might.

Based on the most recent monthly distribution annualized, IDVO currently has a distribution yield of approximately 6.1%. Investors receive those distributions monthly, making the fund potentially attractive for retirees who want more frequent cash flow than SCHD provides.

The obvious downside is cost. IDVO charges a 0.65% expense ratio, nearly 10 times SCHD’s 0.06%. You’re paying considerably more for active stock selection and tactical options management, so the strategy ultimately needs to add enough value to justify that additional expense.

Can IDVO Actually Avoid NAV Erosion?

Covered-call ETFs generally face a structural challenge over long periods. Selling calls generates current income, but it also sells some future upside. During powerful bull markets, a cheap index ETF can simply let its winners run, while a covered-call strategy may repeatedly give away part of those gains. There are exceptions, however, and IDVO has been one so far. Since inception, the ETF has produced a cumulative total return of 116.33% with distributions reinvested, compared with 100.71% for the MSCI ACWI ex-U.S. Index.

I also ran two scenarios using Testfolio covering Sept. 8, 2022 through the present, an almost four-year period. Both started with $10,000 in IDVO, but they treated the monthly distributions differently. In the first scenario, every distribution was reinvested and taxes were ignored. IDVO produced a 114.56% cumulative total return, turning the original $10,000 into $21,456. The second scenario is more relevant for an income investor. Instead of reinvesting the distributions, I assumed the investor withdrew them as cash, again ignoring taxes. Even after continually removing that income from the portfolio, the remaining IDVO shares appreciated 68.64%, leaving a final portfolio value of $16,863 while also providing a consistent stream of monthly distributions along the way.

That’s what I want to see from a covered-call ETF. The distributions aren’t coming alongside a steadily collapsing share value. At least over IDVO’s relatively short history, investors who spent the distributions still finished with substantially more principal than they started with.

One rough sanity check I like is comparing an ETF’s distribution rate with the long-term return potential of its underlying asset class. If an equity covered-call ETF is trying to distribute considerably more than stocks have historically generated in total returns, something eventually has to make up the difference. That could mean unusually strong option premiums, fluctuating distributions, or declining NAV. IDVO’s roughly 6.1% distribution rate gives it considerably more breathing room.

There are no guarantees that its NAV will continue appreciating, and international equities can certainly experience prolonged bear markets. But if the goal is to roughly double SCHD’s income without setting an aggressive double-digit distribution target, I think IDVO offers a more reasonable compromise between current income and preserving principal.

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